Two Dissents From the Hopes for Japan's
Market

EVEN AS WAR THREATENS in Iraq, the world is gearing up to like Japan again. Investors, CSFB reports, are gaining optimism about Japanese companies, citing an average price-earnings ratio of 18, strong free-cash-flow generation, growing foreign ownership and the Bank of Japan's drive to buy shares from banks at an ever-faster rate. Then there's the expectation that shares will rise when Prime Minister Junichiro Koizumi names a new BOJ governor on Feb. 20 to replace Masaru Hayami.

So far this year, the Nikkei 225 is outperforming indexes tracking the world's other major markets; it's down just 1.5%, to 8,448. The yen has swung wildly in recent days as the Finance Ministry confirmed it had intervened heavily in the foreign-exchange market last month and on a report that Koizumi plans to name Nobuyuki Nakahara, a proponent of aggressively expanding the money supply, as the new BOJ governor. The other rumored candidate is Toshihiko Fukui, a more conservative BOJ veteran. The first would probably support "inflation targeting" as a way to reverse Japan's deflation, for which authorities lately have blamed China.

We checked in with two of Tokyo's sharpest observers of the financial markets. Their assessments were skeptical.

Eisuke Sakakibara gained fame as "Mr. Yen," the caustic and outspoken chief of the Finance Ministry's international bureau. In 1995, he engineered the dollar's rise from a low of &yen;80. Today, Sakakibara is a professor at Keio University, helping reformist governors create new platforms. And the yen stands at 120 to the dollar, smack in the center of the &yen;110- &yen;130 range that Sakakibara thinks is its longer-term trading range.

Sakakibara doesn't dispute that China plays some unquantifiable role in Japan's deflationary woes. Still, he adds, "Deflation is global and structural. There's excess supply in manufacturing," and deflation owes much to technological advances and to the emergence not only of China but also of India and Eastern Europe as manufacturing powers.

He's skeptical about the efficacy of inflation targeting, and on that basis might prefer that Fukui lead the BOJ. Setting an inflation target doesn't mean the BOJ actually knows how to introduce inflation into the economy. "No central bank has been effective in fighting deflation, only in fighting inflation," he says. "We're in a liquidity trap, and the only way to change it is to break expectations. If you could show how inflation would be generated, that would do it." But without such evidence, the public won't buy the plan; "the public isn't that dumb."

Indeed, Sakakibara argues that the central bank's role is "limited" in a deflationary context to being a lender of last resort and ensuring a sound financial system. He thinks the bubble in Japanese government bonds will keep expanding as the Bank of Japan pumps money into the system. He also fears that the BOJ, which is buying equities from banks, might be creating a bubble in stock valuations.

Meanwhile, the Ministry of Finance has lost a great deal of power with the ascent of the Financial Services Agency, which monitors the banks, and the powerful Council on Economic and Fiscal Policy. Its reputation has also suffered from various scandals. "The role of the MOF naturally had to decline," Sakakibara says. Still, he laments, there's "no leadership. The vacuum of power is filled by politicians." With Koizumi a "prisoner" of the ruling Liberal Democratic Party and focused on elections this year, "he has no capacity to restructure the Japanese political system," he declares. Yet he considers as dangerous the rising popularity of politicians such as right-wing Tokyo Gov. Shintaro Ishihara.

For now, deflation is "unavoidable," says Sakakibara. Japan must move to avoid a deflationary spiral, by creating an environment in which corporate profits can rise even when sales slump -- by ensuring competition, by major deregulation, by companies overhauling their business models, by corporate Japan resolving its debt problems. Sakakibara favors boosting growth by "throwing the doors open" to immigration and to increased ownership of assets by foreigners. That isn't likely to happen soon.

Japan's immediate prospects are "not good," Sakakibara believes. "Japan entered into a double-dip recession starting last year. The numbers coming out are very weak." Many Japanese companies are aggressively restructuring, but public appetite for reform is limited, thanks to the real rise in wages. "Ordinary Japanese are well off, and people are reasonably satisfied with the status quo," he explains. That will probably change, triggered by a decline in wages, the recession and louder talk about layoffs. How long could it take? "The structural reform we have to go through is deep," Sakakibara observes. "It will take five to 10 years to complete."

Alex Kinmont, the strategist at Nikko Salomon Smith Barney, recently penned a widely read piece entitled "The Irrelevance of Japan." In it, Kinmont argued that Japan today is "of no general importance except as a laboratory experiment concerning deflation" and is rapidly becoming marginalized in the view of global investors. It is "deeply saddening," reported Kinmont, for anybody who is interested in Japan.

At the time Kinmont arrived in Japan in 1989, Japan accounted for about 40% of the world market. Now it's a significantly lower percentage. Thus, having an informed opinion in Japan is a "luxury," and he foresees that big banks and institutions will cease to cover Japan as a big market independent of the rest of Asia. Foreign investors will "trade" Japan rather than invest there.

Japan's financial markets have shrunk more quickly than anybody expected, and become less liquid, too; Korea and Taiwan combined can often exceed turnover in Japan. At the end of last year, non-Japan Asia had a market capitalization of $1.6 trillion and weekly turnover of $25.3 billion. Japan's market cap totaled $2 trillion, but weekly turnover added up to just $10 billion.

Kinmont maintains that ratios in non-Japan Asia look more favorable than Japan. At the end of last year, Japan traded at 33.6 times earnings, compared with 13.2 times for non-Japan Asia, and at 1.3 times book, only fractionally cheaper than the average for its neighbors. Japan's return on equity was 3.9%, in sharp contrast to 10.6%. And earnings in non-Japan Asia grew an estimated 40%, versus 23% in Japan.

So why did Kinmont recently raise his stock market rating to "neutral"? Equity investors, he says, have become "overexcited" by the prospect of a new BOJ governor. At the moment, the market is "embracing the best case" after a long slump. "We pick up a desire among investors that there will be a policy change in Japan and there's no way to disprove that," Kinmont asserts. "The market requires a narrative, which will be a change in the BOJ government." That in turn would drive up shares of banks, brokers, and real estate -- the nexus of inflation beneficiaries. Then there are seasonal factors -- foreigners take riskier bets early in the calendar year, and authorities try to jawbone stock prices higher before the fiscal year ends March 31.

Still, Kinmont maintains that authorities have offered no convincing platform to reverse deflation. "The risk is high," he says, that such investors will "only be more severely disappointed later" in 2003.

In previous years Kinmont was far more sanguine. What happened?

Last year Kinmont went to a friend's bachelor party in Shanghai, his first visit there in 13 years. Confronted by impressive construction -- Shanghai now boasts more skyscrapers than Tokyo -- Kinmont's view of China as a backward producer vanished. He is no blind China partisan, believing that China's quality of growth is as poor as non-Japan Asia's before the '97 currency crisis. But today, he maintains, China could at last be the catalyst that forces Japan to restructure.

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